Import price increases remain muted, keeping interest rates low

The Bureau of Labor Statistics releases its U.S. Import and Export Price Indices monthly. The report keeps track of import prices by locality, type, and fuel versus non-fuel. It also separates commodities and non-commodities. Commodity prices tend to be more volatile than non-commodity prices, so it makes sense to strip them out to get a view of underlying inflation. The U.S. inflation indices, the Consumer Price Index and the Producer Price Index, do the same thing—they give the headline number and then strip out food and energy.

Inflation isn’t the Fed’s biggest concern at the moment. If anything, it’s worried that inflation is too low. It has referred to failing on both sides of its dual mandate, which means it’s not enough to keep inflation low. If inflation is too low, the Fed needs to increase it. This makes sense when you think of monetary policy at the zero bound. With interest rates as low as possible (they can’t go below zero), falling inflation (or even deflation) causes real interest rates to rise. Real interest rates are simply nominal interest rates (the rates you read in the Wall Street Journal) less the inflation rate. Deflation in the context of 0% interest rates is the exact problem Japan has.

Given the muted growth in import prices (partially driven by a stronger dollar), the Fed is anticipating keeping interest rates as low as possible and using other tools, like asset purchases (quantitative easing), to try to spur some economic growth. So far, there has been no evidence of inflation, primarily because there has been extremely modest wage inflation. The classic “wage-price spiral” doesn’t really work when wages aren’t cooperating. The absence of inflation has been a worry for the Fed, which fears deflation.

This should mean that the mortgage REITs, like Annaly (NLY), MFA Financial (MFA), American Capital (AGNC), Capstead (CMO), and Hatteras (HTS), continue to operate in the same environment they have had for the last several years—low returns on assets combined with low borrowing costs. Investors who want to take directional bets on Treasuries should look at the iShares 20-year bond ETF (TLT).